LTCG tax on switching mutual funds: What happens when you sell one fund to invest in another?

Amid a Reuters report suggesting that SEBI has proposed exempting LTCG tax on the sale of existing mutual fund holdings to reinvest in new ones, this article explains how tax currently applies to mutual fund switches and what experts have said about this provision in the past.

Selling one mutual fund scheme to buy another is treated as a redemption and a fresh purchase for tax purposes. This means the gains you book from selling are taxable even if both schemes belong to the same fund house.

There is no tax-free "switch" route, whether you move from a small-cap fund to a flexi-cap fund, from a regular plan to a direct plan, or from a growth option to an IDCW option.

How much you pay depends on the type of fund and how long you held it. For equity-oriented funds, including index funds and hybrids with 65% or more in equity, short-term gains on units held up to 12 months are taxed at 20%, while long-term gains above ₹1.25 lakh a financial year are taxed at 12.5%; long-term gains up to ₹1.25 lakh are exempt.

Debt funds purchased on or after April 1, 2023 have it worse. The entire gain is taxed at your slab rate irrespective of holding period. Units bought earlier may still get the older treatment, with gains after two years taxed at 12.5% without indexation. ELSS gains, after the three-year lock-in, are treated as long-term and taxed at 12.5% above the ₹1.25 lakh threshold.

For investors and taxpayers, planning the switch matters more than the rate itself.

"If you switch after holding your equity funds for more than one year... your gains are taxed as long-term capital gains, which are taxed at a lower rate. Also, gains up to ₹1.25 lakh in a financial year are tax-free, so you can plan your switch to make use of this limit," Soni had said.

Spreading switches across financial years, and setting gains off against capital losses elsewhere, can lower the tax bill further. One should also check the exit load, which applies if you switch before the fund's minimum holding period.